Bonds are becoming increasingly popular among investors, and it’s easy to see why. Bond yields are the highest they’ve been in years, with inflation remaining strong and interest rates at their highest levels since the financial crisis. In late 2023, the yield on the 10-year Treasury note was hovering above 4%, nearly reaching 5% for the first time since 2007. In such a climate, it’s not unexpected that investors are rekindling their interest in bonds.

Bond prices have been volatile in recent years as the Federal Reserve hiked interest rates to combat high inflation, but with an end to rate increases potentially in sight, investors may be able to take advantage of attractive yields in short-term bonds.

Here’s what you should know about short-term bond funds and some of the best ones to consider for your portfolio.

Short-term bond funds are mutual funds and exchange-traded funds (ETFs) that typically invest in government and corporate bonds with maturities of less than five years. Bonds with shorter times to maturity are less sensitive to changes in interest rates than longer-term bonds, meaning investors won’t suffer as much if rates head higher. Remember, interest rates and bond prices move in opposite directions, so as rates rise, bond prices fall and vice versa.

Investors in short-term bond funds earn a yield, which measures the income produced by the bonds in the portfolio relative to the current market price.

Short-term bond funds can make sense for many different investors, but they’re particularly well-suited for those saving towards short-term goals. Money that you think you’ll need in the next three to five years can be invested in short-term bonds, allowing you to earn a decent rate of return without taking on too much risk.

Pay special attention to a fund’s expense ratio, or fee, before investing. All else being equal, the lower the expense ratio is, the better off you’ll be as an investor.

Top Short-term Bond Funds

SPDR Portfolio Short-Term Corporate Bond ETF (SPSB)

The SPDR Portfolio Short-Term Corporate Bond ETF aims to track the performance of the Bloomberg U.S. 1-3 Year Corporate Bond Index. The fund offers exposure to U.S. corporate bonds with maturities between one and three years.

• SEC yield: 5.38 percent
• Expense ratio: 0.04 percent
• AUM: $7.6 billion

iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB)

This iShares fund aims to track the performance of an investment-grade corporate bond index with maturities between one and five years. Holdings include bonds issued by Bank of America, JPMorgan Chase and Microsoft.

• SEC yield: 5.42 percent
• Expense ratio: 0.04 percent
• AUM: $20.8 billion

Schwab 1-5 Year Corporate Bond ETF (SCHJ)

The Schwab 1-5 Year Corporate Bond ETF seeks to track the total return of an index measuring the performance of the short-term U.S. corporate bond market. The fund holds corporate bonds with remaining maturities between one and five years.

• SEC yield: 5.31 percent
• Expense ratio: 0.03 percent
• AUM: $400.2 million

Vanguard Short-Term Bond ETF (BSV)

The Vanguard Short-Term Bond ETF aims to track the performance of a market-weighted bond index made up of investment-grade bonds with a dollar-weighted average maturity of 1-5 years. The fund holds government bonds, high-quality corporate bonds and investment grade international dollar-denominated bonds.

• SEC yield: 4.97 percent
• Expense ratio: 0.04 percent
• AUM: $32.1 billion

Fidelity Short-Term Bond Fund (FSHBX)

The Fidelity Short-Term Bond Fund aims to produce a high level of current income while preserving capital. It typically invests at least 80 percent of its assets in all types of investment-grade debt and maintains a dollar-weighted average maturity of three years or less.

• SEC yield: 4.99 percent
• Expense ratio: 0.30 percent
• AUM: $2.3 billion

Short-term bond funds are a fantastic place to invest money that you could need in the next few years. Keep in mind that these funds do not come without risk, although they are safer than investing in high-yield bonds or the stock market. Money-market funds may be of interest to investors seeking higher yields while assuming less risk.

Top Bonds to Invest in for the Long Term

In addition to the guaranteed fixed income return, bonds provide several additional benefits in a high-interest-rate environment. For example, if interest rates fall, the price of a bond rises, and you may profit by selling your bond rather than holding it until maturity.

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If interest rates continue to rise, more investors will go to bonds for a steady return on their investment. This covers bond funds and bond exchange-traded funds (ETFs), as well as corporate and municipal bonds. If you want to invest in bonds, keep reading to learn about some of the greatest bond and bond fund options available today.

1. 10-year Treasury Note

If you’re looking for a straightforward bond investment, it’s hard to beat Treasuries. U.S. Treasury bonds are considered the safest in the world and are generally called “risk-free.” The 10-year rate is considered a benchmark and is used to determine other interest rates, such as mortgage rates, auto loans, student loans, and credit cards.

Treasury yields are closely tied to the federal funds rate, so they should continue to move higher if the Federal Reserve keeps raising rates.

Currently, short-term yields like the two-year yield are even higher than the 10-year, meaning the yield curve has inverted. That shows that investors expect interest rates to come down within a few years.

2. I Savings Bonds

If you’re looking for another straightforward option, I Bonds — also known as I Savings Bonds — are a great way to earn interest and protect yourself from inflation. Through the end of April 2024, I Bonds were offering an interest rate of 5.27% (1.3% fixed and 3.97% variable). People who buy I Bonds by the end of April 2024 will lock in the 1.3% fixed rate for the life of the bond (30 years), while the variable rate will reset every six months depending on inflation.

I Bonds also pay monthly rather than semiannually, and they can’t be traded. You have to wait a year to cash them in, and their maturities can last as long as 30 years.

Because they adjust for inflation, yields could fall if the inflation rate goes down.

3. iShares TIPS Bond ETF

Like I Bonds, TIPS also offer investors protection from inflation (TIPS stands for Treasury Inflation-Protected Securities). You can buy TIPS directly from the government through treasurydirect.gov. You can also invest in them through ETFs such as the iShares TIPS Bond ETF.

The fund invests in a range of TIPS securities that have at least one year left until maturity, are investment-grade, and have more than $300 million in outstanding face value.

The TIPS ETF paid an impressive yield of 5.7% in late 2023. Like I Bonds, however, yields on TIPS can fall when the inflation rate declines.

4. Nuveen High-Yield Municipal Bond Fund

Investors in bonds generally have two choices. They can invest in investment-grade bonds, which are considered safer but offer lower yields, or they can buy high-yield bonds, which are riskier but pay more.

Municipal bond funds offer one way to get exposure to high-yield bonds and come with the added bonus that the interest is free of federal income taxes and free of state taxes if you buy municipal bonds from your state of residence.

One of the best municipal bond funds is the Nuveen High-Yield Municipal Bond Fund. It offered a 5.0% yield in late 2023, and the fund aims to earn a high current income that’s exempt from federal taxes. It holds mostly lower-quality, long-term municipal bonds.

5. Vanguard Short-Term Corporate Bond Index Fund

Short-term bonds offer some advantages over long-term bonds, depending on your investing needs. Because of the shorter duration of short-term bonds — considered to have maturities of five years or less — they have less interest-rate risk and are more likely to preserve the principal.

Short-term bonds are especially attractive these days because the yield curve has inverted, meaning short-term bond yields are higher than long-term bond yields. One way to take advantage of this is with the Vanguard Short-Term Corporate Bond Index Fund, one of the best corporate bond funds.

The fund holds a range of bonds from blue chip companies such as Boeing (BA 4.31%) and Bank of America (BAC -0.19%). It aims to track the Bloomberg U.S. Corporate 1-5 Year index. The fund offered a yield of 5.6% in late 2023.

6. Guggenheim Total Return Bond Fund

A total return bond fund differs from the typical bond fund by generating returns both through coupon payments and increasing the price of the bond. This can happen either because yields fall, which is generally determined by central banks and macroeconomic forces, or because the fund owns bonds whose credit ratings improve, which also leads to falling yields and rising prices.

The Guggenheim Total Return Bond Fund owns a range of bonds, including Treasuries, municipal bonds, and corporate bonds. It paid a yield of 5.5% as of late 2023.

7. Vanguard Total International Bond Index Fund

If you’re looking for diversification from your bonds, there’s no reason to stay within U.S. borders. Emerging markets can offer some of the best opportunities for high-yield investors, so it’s worth considering international bonds like the Vanguard Total International Bond Index Fund.

The fund’s top holdings are European government bonds, although it holds more than 100 different bonds, largely investment-grade. It tracks a Bloomberg index adjusted to exclude U.S. bonds, and it offered a yield of 3.4% in late 2023.

8. Fidelity Short-Term Bond Fund

If you’re interested in short-term bonds, you don’t have to limit yourself to corporate bonds. The Fidelity Short-Term Bond Fund, one of the best short-term bond funds available, invests in both short-term Treasury bills and corporate bonds from companies such as financial giants Morgan Stanley (MS 1.21%), Bank of America, Citi (C 0.31%), and American Express (AXP 0.45%).

The fund is managed to have a similar overall interest rate risk to the Bloomberg Barclays U.S. 1-3 Year Government/Credit Bond index and aims for a dollar-weighted average of three years or less. It offered a yield of 4.3% in late 2023.

Whether you prefer high-yield, investment-grade, foreign, or domestic bonds, the market offers a diverse choice of bonds and bond funds to meet the demands of nearly every investor seeking fixed income.

In a world of rising interest rates, bonds will only become more appealing. Take the time to choose which type is right for you.

How Does Investing in Bond Funds Work?

Bond funds can diversify your portfolio, but it’s important to understand how they compare to other investments. Like stocks or exchange-traded funds (ETFs), bond funds have both pros and cons. They can be a low-cost option with consistent returns, but they also come with some unavoidable risk. A financial advisor can help you determine which investments belong in your portfolio based on your current financial situation and long-term goals.

Bond funds aren’t all alike. There are several broad categories of bond fund investments, including:

• Investment-grade bonds: This includes bonds that have been classified as investment grade by bond rating organizations. These are high-quality bonds and may include Treasury bonds, mortgage-backed securities, corporate bonds and inflation-protected bonds.
• High-yield bonds: The overall goal of high-yield bond funds is to generate income and consistent returns for investors. While these types of bond funds may offer more reward than investment-grade bonds, they also tend to carry more risk.
• Municipal bonds: Municipal bond funds focus solely on municipal or muni bonds. These are bonds linked to local and state government agencies. When a government entity issues a municipal bond, it allows them to raise funds (using the money you invest in the bond) to pay for public projects like bridges or buildings. The chief advantage of municipal bonds is that they can create reliable income without the higher risk profile of high-yield bonds.
• Multisector funds: Multisector bond funds can include a mix of different bond types, with varying risk and reward profiles. For example, you might find high-, low- and intermediate-quality bonds in this type of fund. You might also have a mix or high-yield and municipal bonds.
• International funds: The bond fund types outlined so far focus primarily on U.S. or domestic bonds. With an international bond fund, you get exposure to foreign bonds as well as those issued by U.S. organizations and companies.

Pros

There are several good reasons to include bond funds as part of your overall investment strategy. According to Mark Charnet, founder and CEO of American Prosperity Group in Pompton Plains, New Jersey, the top advantages of bond funds are:

• No or low minimum investment to purchase
• No maturity date to hold for – can sell at any time
• Professional management and decision making as to which issues to buy or sell
• No charges for exchanging shares into other funds in the family
• A systematic purchase program that costs as little as $50
• Lower costs than a typical portfolio of bonds

Bond funds are a good way to diversify your portfolio, beyond just holding stocks.

In terms of risk, bonds are comparatively less risky than stocks or mutual funds. While you may not earn a double-digit return with a bond fund the way you might with a stock or ETF, the returns you earn from bonds tend to be more consistent and predictable. That’s important if you’re interested in generating some stable income within your portfolio.

Cons

One of the biggest drawbacks associated with bond funds is interest rate risk. Generally, when interest rates rise the value of fund shares can diminish. That can reduce returns. Bonds with a longer horizon until maturity are typically more vulnerable to changing interest rates than short-term bond funds.

Credit risk can also be an issue with bonds and bond funds. Bond funds that include more lower-quality holdings tend to carry more credit risk (meaning more risk of default) than high-quality bond funds. Selecting bond funds isn’t that different from choosing any other investment. It begins with determining your goals, risk tolerance and time horizon, as well as the current interest rate environment.

For instance, if rates are rising, you might be more interested in short-term bond funds. Or, if you have decades to go before you retire, the higher return potential of high-yield bonds might be attractive.

When evaluating an individual bond or bond fund, consider focusing on the fundamentals. The bond or fund’s share price, its 30-day yield, and its total return over time are key to its performance. Also pay attention to the types of bonds in your fund and the fund’s credit risk.

Next, decide what percentage of your portfolio should include bonds and bond funds. For example, a 60/40 portfolio is a 60% to 40% split between stocks and bonds. Using the rule of 110, however, you’d subtract your current age from 110 to get the percentages you should allocate to stocks and bonds. So, if you’re 30 years old, the rule of 110 would dictate putting 80% of your portfolio in stocks and the rest in bonds.

Bond Funds and Taxes

Gains from bond funds, like those of any other investment, may be subject to tax. If you’re holding them in your 401(k) or a traditional IRA, taxation would be deferred until you begin making qualified withdrawals. With a Roth IRA, your withdrawals are always tax-free as long as they’re qualified.

But if you hold bond funds in a taxable brokerage account, you’d be subject to capital gains tax if the fund distributes dividend income or capital gains. You’ll also be taxed if you sell the fund at a profit. This typically doesn’t apply to municipal bonds, which are usually tax-exempt.

Bottom Line

Investing in bond funds does not need to be complicated. If you understand how bonds and bond funds function, as well as where they fit in your overall portfolio, they may be a wise investment.

Bond funds can assist to mitigate some of the volatility associated with stock investing while also generating income over the short or long term.